Commentary and musings on the complex, fascinating and peculiar world that is securities regulation

Monday, November 01, 2010

SEC Issues Progress Report on IFRS Incorporation Work Plan for U.S. Issuers

The SEC Office of the Chief Accountant and the Division of Corporation Finance released a progress report on the SEC's work plan for considering whether to incorporate International Financial Accounting Standards (IFRS) in U.S. issuers' financial reports. The report examined whether IFRS is sufficiently developed for U.S. issuers, the independence and funding of the International Accounting Standards Board (IASB), investor education, the regulatory environment, the impact on issuers, and human capital readiness.

The report stated that the evaluation of IFRS sufficiency must focus on the comprehensiveness of IFRS, the auditability and enforceability of IFRS, and the comparability of IFRS financial statements within and across jurisdictions. Comprehensiveness is measured by looking for areas where IFRS either does not provide guidance or provides less guidance than U.S. GAAP, determining how issuers deal with the lack of guidance, and identifying areas that would benefit most from more guidance. Auditability and enforceability must be evaluated to determine the factors that influence consistent audit and enforcement. In particular, the staff will consider audit and regulatory concerns, error correction and enforcement trends, and the practical experiences of securities litigators and regulators. The staff will consider the areas where auditors and regulators may lack the ability to require preparers to meaningfully account for transactions. The staff also will examine the role played by prescriptive guidance in accounting standards in enforcement actions under U.S. GAAP and IFRS.

Moreover, the staff will review the use of interpretative guidance in IFRS audits and enforcement, and whether standards issued by the Public Company Accounting Oversight Board must be modified under IFRS. The staff's evaluation of comparability across jurisdictions will look at factors that influence comparability, the extent to which IFRS is not comparable, how investors deal with the lack of IFRS clarity, and how to improve IFRS comparability. Comparability also requires evaluation of how other jurisdictions incorporate IFRS into their financial reporting regimes, review of compliance trends across industries and jurisdictions, understanding of audit and regulatory processes (especially client base diversity and the handling of identical fact patterns), information sharing among securities regulators, and stakeholders' recommendations on key comparability issues.

The staff stated its preliminary observations on the incorporation of IFRS. The staff's report noted that countries incorporate IFRS into their GAAP either by adopting IFRS as issued by the IASB or by following a national incorporation process. Adoption of IFRS as issued by the IASB, the staff observed, would result in the most consistent adoption of IFRS globally, but can undermine the authority of local regulators. Adoption of IFRS through a national incorporation process, by contrast, provides local regulators the freedom to address country-specific issues, but can undermine the effort to adopt global standards. To date, according to the report, a "small minority" of large countries have adopted IFRS as issued by the IASB. Instead, most adopting countries have engaged in a national incorporation process that follows either a "convergence approach" or an "endorsement approach."

Countries opting for convergence do not explicitly adopt IFRS, but instead gradually converge local accounting standards to IFRS. The report cited China as an example of convergence. Countries following the endorsement approach incorporate IFRS into domestic GAAP. The endorsement approach can result in wide deviations from IFRS as issued by the IASB. The majority of countries adopting IFRS follow the endorsement approach, including many European Union countries complying with European Union law.

The report addressed whether the IASB is sufficiently independent for IFRS to be the single standard for U.S. issuers. Here, the report examined oversight of the IFRS Foundation, composition of the IFRS Foundation and the IASB, funding of the IFRS Foundation, and IASB standard-setting processes. The staff's preliminary observations focused on funding of the IFRS Foundation. The IFRS Foundation and the IASB cannot impose funding requirements; funding instead occurs informally but is, in principle, based on each adopting country's gross domestic product.

The report observed that three-fourths of IFRS countries provide no funding to the IFRS Foundation, and that the U.S. and Japan (both non-IFRS countries) made the largest contributions in 2009. The report considered the SEC's authority to recognize "generally accepted" accounting standards under Sarbanes-Oxley Act (SOX) Sections 108 and 109. The SOX legislative history states that stable funding independent of the accounting industry is a key factor. In the IFRS context, SOX Section 108 requires a standard-setter to abide by majority vote, whereas the IASB mandates a super-majority. The accounting support fee and annual SEC fee review required under SOX Section 109 might not be possible for the IASB.

The regulatory environment is an important factor in IFRS adoption. The report noted that the staff is focused on how the SEC would fulfill its mission, the impact on industry regulators, federal and state tax impacts, audit regulation and standard setting, broker-dealer and investment company reporting, and accounting standards for public and private companies. An overarching concern is the method of IFRS incorporation due to the many references to U.S. GAAP in U.S. laws, regulations, and contracts. Industry regulators, for example, may need to adjust financial metrics to comply with IFRS and/or modify metrics used to evaluate regulated institutions. IFRS adoption thus could result in high costs for full convergence, a dual GAAP regime for public and private companies, reduced regulator influence over standard-setting, and the lack of industry-specific guidance now available under U.S. GAAP.

Tax implications include the use of the LIFO inventory method and the calculation of earnings and profits. The staff is also reviewing how IFRS may affect broker-dealers and investment companies, including how IFRS would impact net capital requirements (to the extent not addressed by MoU projects). The staff is working with the SEC's Trading and Markets and Investment Management divisions as well as conducting outreach to industry groups, including the Financial Industry Regulatory Authority, the Securities Industry and Financial Markets Association, and the Investment Company Institute.

In addition, the report noted efforts to better understand the impact on issuers. Key issuer concerns include accounting systems and controls, contracts, corporate governance, accounting for litigation contingencies, and accounting standards for smaller and larger companies. Investor education, the report stated, is critical because the benefits of a global accounting standard depend on investors' confidence in the financial results reported by issuers using the standard. The SEC has issued a request for comments (http://www.sec.gov/rules/other/2010/33-9134.pdf) on U.S. knowledge and preparedness regarding IFRS. The comment period ended October 18, 2010, and the staff is reviewing the comments submitted. The report noted some development in U.S. investor education about IFRS. The report also stated that more must be done to evaluate readiness, including an evaluation of auditor capacity as well as training and education, including a review of college curriculums.